A Government Shutdown Could Deepen the Debt Crisis

Though the threat of a government shutdown has faded with the passage of a compromise measure to fund the federal government for the next 2 weeks (and cut $6 billion of spending), we should expect an even more difficult debate in Congress over how to keep Washington running through the end of the fiscal year. Now that the low-hanging budgetary fruit has been picked – cuts that both parties had already essentially agreed on – it’ll be a matter of how many further cuts Republicans can force through.

In the midst of these furious discussions over potential compromises, some have suggested that it wouldn’t be a big deal for the government to shut down after all. A Quinnipac University poll suggested almost half of Americans (46 percent) think that a shutdown wouldn’t be a big deal. Former Minnesota governor (and potential 2012 presidential candidate) Tim Pawlenty called a shutdown “an option I think Republicans have to consider” to bring Democrats to heel. Others have commented that a shutdown is not something to worry about, since the government brings in more than enough money in tax revenue to cover debt service payments, making a default unlikely.

Both of these views are missing the point. It’s likely that the direct effects of a shutdown wouldn’t completely derail the economy (Goldman Sachs has attempted to estimate the effects). But it could have a more subtle, but equally harmful effects on the sentiment of the U.S. government’s debtholders.

As The Fiscal Times details, a government shutdown could spook investors already worried about the wavering commitment to meaningful budget reform on both sides of the aisle. If a shutdown shakes the market, interest rates could spike, increasing interest payments on our existing debt (already scheduled to increase about 350 percent over the next ten years) and making future borrowing more difficult.

What’s at stake here? A 2010 sovereign debt outlook from Moody’s estimated that a sudden 2 percent rise in rates could bring interest payments on the federal debt to 14 percent of total receipts by 2012. Today, they’re about 9 percent. That level of interest-payments-to-total-receipts could also bring the downgrade of the federal government’s creditworthiness that spectators have been dreading.

If, as budget negotiations continue, either side is tempted to move for a government shutdown, they should be aware that the consequences will take not only a direct, economic form – employees furloughed, payments and services halted – it could do long-term damage to our already precarious debt situation. Would that really be worth it?